Shelter Capital Gains Using New Qualified Opportunity Funds
Embedded in last year's tax reform bill was a new and unique provision that to this point has not received the attention it deserves; the creation of "Opportunity Zones" and the ability to defer or even completely avoid some capital gain taxes when investments are made in a so-called "Qualified Opportunity Fund' (QOF).
This new law allows you to defer paying tax on current capital gains realized from the sale of assets such as real estate, stocks, and mutual funds, by investing those gains in a qualified QOF. Further, if held long enough, some of those deferred capital gains may avoid taxation forever, as could any post-investment appreciation in the QOF.
Opportunity zones were established under the law in areas all across the country based on income demographics to encourage investment in these areas and to aid in their economic development. Arkansas has many such zones scattered around it; 85 in all.
A QOF is an entity that is formed for the purpose of investing in qualified opportunity zone property and that holds a minimum of 90% of its assets in such property. A QOF can be formed by an individual or company, and many are being put together by investment managers as another option for investing.
Here is how, in general, this works:
A taxpayer incurs a capital gain through the sale or exchange of capital assets. They then have 180 days from the date of sale to invest the gain in a QOF. If they do so and make the proper election, the realized gain is deferred, meaning you will not pay tax on it in the year of sale.
By the way, in the case of a capital gain realized by a pass-through entity, such a partnership, LLC or S corporation, the election can be made by either the entity or the owner, and if made by the owner, the 180-day period for reinvestment begins on the last day of the pass-through entity's tax year in which the gain occurred.
So how does this help you?
Well, first of all, taxation on the gains is deferred all the way until December 31, 2026, or until you sell the QOF, if earlier. That is a long time to be able to put off paying the tax.
Secondly, the longer you hold the QOF, the better the tax benefit. If you own the QOF at least five years, 10% of the original gain becomes tax-free. If you hold it for seven years, another 5% becomes tax-free, for a 15% total.
Finally, if you hold your QOF investment at least ten years, an election can be made such that all appreciation in value on the QOF over and above your original investment is never taxed!
One caveat though; it is important to understand that in 2026, tax will have to be paid on whatever deferred gains remain at that point, even if you still own the QOF and plan to hold it for at least ten years to take advantage of that last benefit, so a source of funds to pay that tax will need to be available.
The opportunity (no pun intended) for significant tax savings here is enormous. As an example, I have a client that was given an asset by a family member a long time ago in which he has locked a large of amount of gain. He currently has a relatively high annual income and associated income tax rate but needs to sell the asset. We are looking for a QOF in which to invest so he does not have to pay the capital gains tax this year.
By the time the tax is ultimately due in 2026, he will have retired, and his income will be much lower, as will likely be his tax rate. Further, by then, 15% of the deferred gain will be tax-free. It is projected that his total tax savings could be as high as $40,000, not accounting for any tax-free appreciation he could have if he holds the QOF at least ten years.
Your gain and potential savings may not be that high, but could still be very substantial relative to your situation. Investment managers are gearing up now to form and offer QOF investment products to take advantage of this unique opportunity.
Of course, you can also go it alone by forming a QOF entity of your own. It is really not that big a deal, however, be sure you engage a qualified tax professional to help you navigate those waters. The rules are fairly specific, so you do not want to inadvertently fail to dot some "i" and cost yourself considerable savings.